My name is Sam Millette, and I’m a fixed income analyst on the Investment Management and Research team here at Commonwealth. I focus on analyzing individual municipal bonds (munis) for our advisors and their clients. As you are likely aware, munis are primarily bonds that have been issued by local municipal governments to finance public investments. Income from these bonds is often exempt from federal and state income tax, which makes them attractive investments for high-net-worth individuals in a high tax bracket.
Recently, we have been getting questions from advisors about our outlook for munis, given the disappointing start to the year. In general, we have a positive view for munis due to strong investor demand, low supply, and improving credit fundamentals.
Here, I’d like to focus on how two recent Supreme Court rulings may help boost the muni market going forward.
The first case, South Dakota v. Wayfair, Inc., pitted the state of South Dakota against a handful of online retailers. The dispute centered on whether South Dakota could charge sales tax on online purchases from out-of-state companies. In a 5–4 vote, the Supreme Court ruled that states have the right to charge sales tax on purchases from out-of-state businesses. Previous court rulings had allowed states to tax a retailer only if it had a physical presence (e.g., a storefront or warehouse) in the state.
With this decision, states will be able to charge sales tax on all online purchases, which eliminates the local-presence loophole that some companies had previously used to avoid collecting income tax. Online retail sales currently make up nearly 10 percent of all sales in the U.S., so this important stream of tax revenues should be a windfall for states. This ruling is especially positive for states that collect a high percentage of their taxes through sales tax.
For the muni market, some of the states that should see the biggest bumps in revenue from this ruling include Washington, Texas, and Florida.
Right to work
The second case that will have a positive impact on munis is Janus v. American Federation of State, County, and Municipal Employees, Council 31. This widely followed labor case questioned the issue of mandatory public union fees. This debate has become politically charged, and the states were roughly split between whether they allowed the practice prior to this ruling. Previously, some states allowed public-sector unions to require fees from nonunion government employees, while other states banned this practice. The states that had banned these mandatory fees are collectively referred to as “right-to-work” states. In states with and without right-to-work laws in place, however, unions were required to treat nonunion government employees virtually the same as union members, whether or not they were required to pay dues.
In another 5–4 June vote, the court ruled that requiring nonunion government workers to support unions with mandatory fees was unconstitutional. At first, it may be difficult to see exactly what impact this decision will have on municipalities. But this is arguably a much bigger deal than the sales tax ruling, and its impact should be analyzed regardless of one’s views on the justness of the decision.
Public unions that represent municipal employees can have an extremely large impact on a municipality’s finances. Wages and retirement benefits are some of the largest expenses that municipalities have, and these are directly negotiated between the local governments and the public unions. By getting rid of mandatory union fees, public unions will see not only a drop in cash collections but also a drop in union members. In turn, fewer union members will give them less bargaining power at the negotiating table.
An example of how big of an impact this change can have on municipalities can be seen by comparing the former right-to-work states with states that previously allowed mandatory fees. One of the factors we can compare is the average pension funding ratio, which broadly measures how much a pension system has relative to what it needs to meet its future obligations. As of 2016, right-to-work states had an average funding ratio of 73.4 percent, while states that allowed mandatory union dues averaged 62 percent. This is just one measure of fiscal health, but public pension funding levels have already started to get more attention in the muni world as baby boomers retire and funding levels remain dangerously low in many states.
The states that will be most affected by this new ruling are mainly concentrated in the Northeast and the West Coast. California, New York, and Illinois are expected to lose the most public-sector union members, which in turn should lead to lower employment costs and potentially better pension funding down the road.
Tailwind for 2018 and beyond
Both of these recent court cases should provide an additional tailwind for munis this year and beyond. We have already seen at least one state that maintained its double-A credit rating due to pension reform driven by right to work, and almost all states should benefit from additional online sales tax revenues.
While munis muddled through the first half of the year, these beneficial rulings—along with continued investor demand and low supply—bode well for performance for the rest of the year.